Are Rolls-Royce (LSE: RR) shares a good buy as we head into 2023? Well, the price has been creeping up as we reach the end of 2022. And I can see positive sentiment increasing.
Flyers return
In the third quarter of 2022, passenger capacity at International Consolidated Airlines returned to 81% of its 2019 level. Short-haul and North American routes hit 91%. These numbers are ahead of the second quarter, and part of a trend that’s been strengthening all year.
It’s happening across the industry too, with easyJet reporting strong passenger numbers for the year ended September.
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This means more miles on Rolls-Royce engines, and more maintenance revenue, which is where the bulk of profits come from.
It looks like we could see a bit of belt-tightening over the next couple of years. So there’s sure to be pressure there. But it could be the beginning of a long-term trend.
Earnings growth
It might seem a bit early to talk about earnings growth. But analysts are wasting no time in predicting exactly that over the next few years.
Rolls is turning profitable again, though only just. We’re looking at a forecast price-to-earnings ratio (P/E) of 70 or so.
But forecasts for 2023 show it coming down sharply. And by 2024, the City folk seem to think it could be down to around 13. That’s below the FTSE 100‘s long-term average valuation.
And you know what? Analysts even think a dividend could be back on the cards too. They only have a yield of around 2% marked in for 2024. But compared to how things were in the depths of the pandemic, it looks like good progress to me.
Cash generation
Profit is all very nice, but Rolls-Royce has needed to take on a lot of debt to survive these past few years. At the last count, there was about £4bn in drawn debt outstanding. That’s after a programme of disposals and the repayment of £2bn in debt, but there’s only so much a company can sell off.
Rolls-Royce will need some decent cash flow over the next few years as individual debts mature. The company still expects “modestly positive free cash flow in 2022“.
It’s only a start, though. But rising cash flow in 2023 and beyond could be another reason to consider buying.
Valuation
Despite positive trends, I wouldn’t rate Rolls-Royce shares a no-brainer purchase by a long way. My biggest concern is the value of the stock. We do have that forecast P/E of 13, but that’s for two years out. And it could be two tough years. It also doesn’t account for debt.
If I add net debt to the market cap, and recalculate the P/E from that, I’m using what’s called an enterprise valuation method. It’s based on what an investor would have to pay to buy the whole company and pay down the debt.
It gives me a P/E of 20. And that’s on top of what might be over-optimistic forecasts by analysts to start with.
Is that a low enough valuation to compensate for the risks? Not for me. So, while I see increasing reasons to buy, it’s enough to keep me away for now.
